The Challenges for Greek Monetary Policy on the Eve of Euro-Zone Entry
15/02/2000 - Speeches
Address by Nicholas C. Garganas
Deputy Governor of the Bank of Greece
"The Challenges for Greek Monetary Policy
on the Eve of Euro-Zone Entry"
It is a great pleasure on the occasion of the Euromoney International
Bond Congress to be given this opportunity to speak to you about recent developments in
the Greek economy and I would like to thank Eurobank and Deutsche Bank for having invited
me here tonight. I believe that this is a particularly interesting time for Greece as she
prepares for entry into the euro-zone on 1 January 2001. I want to begin by looking at the
impressive progress made by the Greek economy over recent years before going on to discuss
some of the challenges which monetary policy, in particular, faces over the coming months.
In recent years economic policy in Greece has been oriented towards
achieving a high degree of sustainable economic convergence and fully satisfying the
criteria set by the Maastricht Treaty for participation in the third stage of EMU by the
time compliance is examined in 2000. Fiscal and monetary policies were implemented
vigorously and the targets of the last two convergence programmes were met, thus placing
Greece directly on the road to joining the euro-zone by 1 January 2001.
Three of the four convergence criteria of Article 109j(1) of the Treaty
– the government budgetary position and public debt, the exchange rate and long-term
interest rates – are already fully satisfied, and the fourth - the criterion on price
stability - will be fulfilled by the end of this month.
On 29 November 1999, the Ecofin Council abrogated its decision that an
excessive deficit existed in Greece; indeed, the general government deficit reached 2.5
per cent of GDP in 1998, well below the Treaty reference value. In 1999, the general
government deficit was further reduced to 1.5% of GDP, below the projection of the 1999
budget. Cyclical adjustment of the government balance shows that the budgetary position of
Greece has already been in compliance with the requirements of the Stability and Growth
Pact from 1999. As can be seen from Figure 1, left hand scale, in 1993 the deficit was
13.8 per cent of GDP.
The debt-to-GDP ratio peaked at 111.6 per cent in 1993 (Figure 1, right
hand scale), was broadly stable thereafter, and started to decline in 1997. It was reduced
by 3.1 percentage points in 1998 and a further 1.2 percentage points in 1999, despite some
additions of below-the-line debits. At about 104 per cent of GDP, its level is still very
high, but is now very firmly on a downward path.
With regard to the criterion on exchange rate stability, the Maastricht
Treaty stipulates that the criterion will be satisfied if “a Member State has respected
the normal fluctuation margins provided for by the exchange-rate mechanism (ERM) of the
European Monetary System without severe tensions for at least two years before the
examination” of compliance with the convergence criteria.
The drachma entered the ERM in March 1998 at a central rate of 357 per
ECU, just over 12 per cent below the market rate prevailing at the time. As from January
1999, it joined ERM II at a central rate of 353.109 per euro, with the standard
fluctuation band of plus or minus 15 per cent.
High interest rate differentials and favourable expectations concerning
Greece's convergence prospects resulted in large capital inflows. As can be seen from
Figure 2, the drachma appreciated (first against the ECU, and since January 1999 against
the euro) and traded at around 7 per cent above its central rate for the best part of
1999. The central rate of the drachma was revalued by 3.5 per cent against the euro on 15
January this year. The new central rate of the drachma is 1 euro=340.75 drachma, and the
standard fluctuation band of plus or minus 15 per cent continues to be observed around the
These developments in the exchange rate, presented in Figure 3,
indicate that the Greek drachma has successfully participated in the ERM for two years
without experiencing any severe tensions during the period under review. Throughout, the
drachma has been above its central rate, reflecting the favourable conditions in the Greek
economy. Therefore, in my view, Greece fulfils the exchange rate criterion.
Financial markets have reacted favourably to Greece’s good
convergence prospects and the spread between the 10-year yield on government bonds and
German bunds in February was around 98 basis points, compared with 196 basis points in
March 1999 and 425 basis points in September 1998. The 12-month moving average of the
yield on 10-year government bonds, used to test for convergence, has been below the
reference value (derived from the average interest rates in France, Germany and Austria,
the three best performing Member States in terms of price stability) since November 1999
(Figure 4), and therefore Greece fulfilled the criterion on the convergence of interest
Progress towards price stability is also very substantial. The
objective of the Bank of Greece is for consumer price increases not exceeding 2%. This
target was reached in August 1999. The annual rate of inflation was 2 percent in terms of
the national CPI, which corresponds to 1.5 per cent for the harmonised index of consumer
prices. Recent price developments (Figure 5) suggest that while the downward trend in
headline inflation has been reversed since October 1999, partly as a result of rising oil
prices, the underlying trend was still declining in December 1999. Headline inflation
eased to 2.6 per cent in January 2000 on an annual basis, from 2.7 per cent in December
1999, while the underlying index edged up marginally from 1.8 per cent in December 1999 to
1.9 per cent in January 2000 (see figure 5). The harmonised index of consumer prices has
been converging rapidly since the beginning of 1999 (Figure 6), exceeding the reference
value by only 0.2 percentage points in January 2000, down from 2.5 percentage points in
January 1998. Although the increase in oil prices has been slowing down the process of
disinflation in recent months, current projections suggest that, in the 12 months ending
in February 2000, Greece should have an average rate of inflation, on a harmonised basis,
below the reference value (Figure 6).
The fall in inflation was achieved under conditions of accelerating
economic growth and rising real incomes. As can be seen from Figure 7, GDP grew at 3.5 per
cent in 1999 – the third successive year above 3 per cent and the fourth year of growth
faster than the EU average. Real convergence with our European partners is expected to
continue, with growth of 3.8 per cent projected for 2000 and over 4 per cent for 2001.
One area in which performance is not satisfactory is the labour market.
Unemployment is at about 10.5 per cent of the labour force, above the EU average (Figure
Although employment has been growing steadily, the labour force is also
growing fast as a result of large immigration and increasing participation. Last year, the
government adopted a National Action Plan for Employment, which relies on a range of
intensive employment – enhancing measures. However, it is somewhat too early to assess
the effectiveness of these measures.
So much for recent developments and the results that Greece has already
achieved in the convergence process. Let us now look at the challenges ahead.
In the coming months, the main challenge for economic policy in Greece
will be to secure the sustainability of the ongoing disinflation process so as to ensure a
smooth transition to the common currency within a healthy growth environment.
Progress towards price stability reflects a number of important policy
choices, most notably the tight stance of monetary policy adopted to date, centered on
high short-term interest rates and a strong drachma (Figure 8). The reduction in inflation
is also supported by the tight stance of fiscal policy and by the slowdown in the growth
rate of unit labour costs (Figure 9). Unit labour costs registered a substantial
deceleration following the two-year wage agreement, signed in the private sector in May
1998. Unit labour costs in the whole economy increased by 2.5 per cent in 1999, down from
5.5 per cent in 1998 and 8.4 per cent in 1997. In the manufacturing sector the
deceleration was more pronounced as a result of improving productivity (Figure 9).
As the changeover to the euro approaches, so domestic short-term
interest rates will have to align with those in the euro-zone and the exchange rate
converge to its central ERM parity. Table 1 provides some indication of the gap between
official interest rates in Greece and those in the euro-zone. The consequence of
convergence is that monetary conditions will inevitably loosen. The question which clearly
arises therefore is the extent to which this development represents a possible threat to
the sustainability of price stability.
A useful point which can be made at the outset is that the impact of
monetary policy loosening on inflation may well be diminished by the openness of the
financial system in Greece, the dampening effect on household incomes of decreasing yields
on financial assets and the fact that economic agents have already anticipated the fall in
domestic short-term interest rates. However, this is not to say that the Bank is not
taking the issue seriously. On the contrary, we are carefully monitoring the situation.
Indeed, the Bank supported fully the recent 3.5 per cent revaluation of
the Drachma central rate within ERM II. By reducing the amount of exchange rate
convergence required, this step will considerably reduce the foreseeable negative effect
on domestic inflation. It is now expected that the depreciation that will occur until the
end of this year will have little impact on inflation. Last week the drachma traded at
around 2.25 per cent above its new central ERM parity. The impact of a depreciation of the
drachma towards its central ERM parity is negligible: given that the share of imports in
consumption is about 22 per cent in Greece, the depreciation of the drachma required for
it to reach its central parity is estimated to imply an acceleration in consumer price
inflation of not more than 0.4 of a percentage point.
Developments after the March 1998 devaluation provide evidence of
Greece's ability to absorb external shocks and to implement non-accommodating policies
when required. Aggregate demand slowed down as a result of restrictive fiscal and incomes
policies, though a tight stance of monetary policy still had a central role in containing
pressure on prices.
The revaluation has facilitated some convergence of interest rates by
allowing a reduction without implying a loosening of the overall stance of monetary
Developments in interest rates and the exchange rate since the
revaluation of the central parity suggest that markets largely discounted the effects of
the revaluation (Figure 10). A downward trend in the 3-month Athibor-Euribor differential
was noticeable from the third week of November onwards. Developments in the foreign
exchange market were broadly similar, with concerns about whether a central rate
adjustment would occur and, if so, its extent, along with seasonal factors, causing some
weakening of the drachma in December. Following the revaluation, the market adjusted
quickly with the implied December 2000 forward rate moving to the new central rate of
340.75 drachmas per euro.
Thus the revaluation, in combination with the fact that interest rate
declines have already been largely discounted, suggest that the impact of the monetary
policy “shock” will be considerably less than initially anticipated. Overall, it is
not now expected that it will be very significant. That having been said, however,
interest rate policy in the remainder of the year will proceed cautiously. The timing and
magnitude of changes in interest rates by the Bank of Greece will be dictated by
developments in inflation and the evolution of the exchange rate. We intend to ensure a
smooth transition to euro-zone membership in both money and foreign exchange markets.
In view of the forthcoming easing of monetary policy, other policies
– notably, fiscal policy, but also, wage and structural policies - will become the
pre-eminent instrument available to counter possible inflationary pressures and ensure
sustainability of low inflation.
The new convergence programme which was recently presented to and
accepted by the Ecofin Council envisages a further tightening of fiscal policy, targeting
a general government deficit of 1.2 per cent of GDP for this year and a primary surplus of
6.7 per cent. For 2001, the target deficit is 0.2 per cent, followed by a small surplus in
the following year. The general government primary surplus is projected to rise again to 7
per cent of GDP for both years. Maintaining the level of the primary surplus may become
the most reliable policy instrument available to hold back demand and ensure price
As regards wage developments, the updated Greek convergence programme
implies moderate wage increases in the public sector in 2000 and beyond. The conditions of
the renewal of the two-year wage agreement for the private sector that has just lapsed are
of particular importance. As I mentioned earlier wage moderation was a key factor that
contributed to lowering inflation and inflationary expectations in the aftermath of the
1998 devaluation, suggestive of an incipient culture of stability that will be essential
in the forthcoming wage negotiations. A credible targeting of inflation and the
maintenance of the announced target in all circumstances have also created a favourable
climate that may positively affect the outcome of the impending wage agreement. The
behaviour of economic agents might also be influenced by awareness of the consequence of a
regime change: the exchange rate instrument will no longer be available as a solution to
competitiveness losses once Greece has become a full member of the euro-zone.
Finally, deregulation and structural reform aimed at enhancing
competition and improving the functioning of individual markets (the goods, services,
capital and labour markets) are also helping price stability. In this context, it is
important to mention that key sectors of the economy, such as electricity and fixed
telephony, are programmed to be opened to competition as from 2001 in accordance with an
EU timetable. Additionally, conditions on the supply side of the economy have been
improving in recent years. The acceleration of private capital formation, the improvement
in infrastructure and the structural reforms (including privatisations) implemented so far
have most likely increased the productive potential of the economy.
To conclude, the Greek economy has come a long way over the recent
past. Tight monetary and exchange rate policies have been instrumental in fighting
inflation. The inevitable reduction in interest rates implied by participation in the
euro-zone and a return of the Drachma to its central ERM rate would represent an easing of
monetary conditions with a foreseeable impact on inflation. I have tried to argue today
that the inflationary impact of gradual interest rate and exchange rate convergence should
not be very significant. The support of other policies, in particular, further fiscal
consolidation, persisting wage moderation and continued progress towards structural reform
should prevent any significant inflationary pressure resurgence when monetary policy eases
and ensure a smooth transition to the euro on 1 January 2001. The outlook for Greece once
in the euro-zone is good, suggesting that in the long run she will be in a position to
reap the full benefits of EMU membership.